Table: Market Implied Regime Expectations and Three Year Return Forecast

We use the following table to provide insight into the weight of market views about which of three regimes - high uncertainty, high inflation, or normal growth - is developing. The table shows rolling three month returns for different asset classes. The asset classes we list under each regime should deliver relatively high returns when that regime develops. We assume that both the cross-sectional and time series comparisons we present provide insight into the market's conventional wisdom - at a specific point in time - about the regime that is most likely to develop within the next twelve months. To obtain the cross-sectional perspective, we horizontally compare the row labeled "This Month's Average" for the three regimes. In our interpretation, the regime with the highest rolling three month average is the one which (on the specified date) the market's conventional wisdom believed was the most likely to develop.

For the time series perspective, we vertically compare this month's average rolling three month return for a given regime to the regime's rolling three month average three months ago. We believe this time series perspective provides insight into how fast and in what direction the conventional wisdom has been changing over time.

Rolling Three Month Returns in USD		30-Sept-2009
High Uncertainty	High Inflation	Normal Growth
Short Maturity US Govt Bonds (SHY)	US Real Return Bonds (TIP)	US Equity (VTI)
0.76%	2.93%	16.36%
1 - 3 Year International Treasury Bonds (ISHG)	Long Commodities (DJP)	EAFE Equity (EFA)
4.87%	3.82%	19.36%
Equity Volatility (VIX)	Global Commercial Property (RWO)	Emerging Equity (EEM)
-2.81%	30.06%	20.73%
Gold (GLD)	Long Maturity Nominal Treasury Bonds (TLT)*	High Yield Bonds (HYG)
-2.91%	3.56%	8.53%
This Month's Average	Average (with TLT short)	Average
-2.66%	4.81%	10.03%
Three Months Ago:	Three Months Ago:	Three Months Ago:
3.65%	17.76%	34.72%

* Falling returns on TLT indicate rising inflation expectations

As you can see, at the end of end of last month, the conventional wisdom still seemed to favor a relatively quick return to normal times (though with an undercurrent of worry about higher inflation). From a dynamic perspective, however, we can see that rate at which these expectations were improving has sharply slowed. In addition, we can see a renewed concern with the possible return to a high uncertainty regime (e.g., the proverbial W, U, or L shaped recession profile). Psychologically, we can understand the need to cling to the view that good times are about to return; we can also understand that in some cases this need is reinforced by the incentives facing some professional investors. However, as we describe at length in this month's Economic Update, we believe that this hope is misplaced, and that the probability of moving again into the high uncertainty regime is quickly rising.

At the request of many readers, we will now publish forecasts for real returns on different asset classes. They can be compared to asset class return forecasts regularly produced by GMO, to which many of our readers also subscribe. Given our belief that foresight accuracy is improved by combining the outputs from different forecasting methodologies, we have taken a different approach from GMO. As we understand it, they start with their estimate of current over or undervaluation, and assume that these will return to equilibrium over a seven year business cycle. They apparently believe that the use of this time horizon will cause a number of ups and downs caused by cyclical and investor behavior factors to average out. It has always struck us as a very logical approach.

In contrast, the forecasting approach we have taken is grounded in our research in to the performance of different asset classes in three regimes, which we have termed high uncertainty, high inflation and normal times. In the latter regime, asset class returns are strongly attracted to their equilibrium levels - i.e., to the situation in which the returns supplied and the returns demanded are close to balance. Our approach to estimating returns under this regime is to appropriate risk premiums for different asset classes to our estimate of the equilibrium yield on risk return bonds when the system is operating under normal conditions. In contrast, the high uncertainty and high inflation regimes are very much disequilibrium conditions in which investor behavior dominates the returns that are actually supplied. Under these regimes, our approach to return forecasting starts with our estimate of what the real rate of return would be (lower than normal under high uncertainty because of a lower time discount rate, and lower still under high inflation because of much stronger investor demand for inflation hedging assets like real return bonds). We then add an estimate of the realized return spread over the real bond yield for each asset class in the high uncertainty and high inflation regimes. To determine these premia, we began with the results from our historical regime analysis, and subjectively adjusted the results to make them more consistent with each other while generally preserving the rank ordering of asset class returns from our historical regime analysis. The final step in our methodology is to subjectively estimate the percentage of time that the financial system will spend in each of the three different regimes over the next 36 months. We are the first to admit that this is, at best, a noisy estimate of the returns investors are likely to receive on different asset classes over our target time horizon. We have no doubt that GMO would say the same about the results produced by their methodology. Indeed, it is either naive or misleading to say anything else, given that one is attempting to forecast results produced by a constantly evolving complex adaptive system. As always, we stress that research has shown that accuracy can be improved by combining forecasts produced using different methodologies. With that admonition, our results are as follows:

Regime	Normal Regime	High Uncertainty Regime	High Inflation Regime	Forecast Annualized USD Real Return
Assumed Regime Probability Over Next 36 Months	20%	50%	30%
Real Rate Under Regime	3.50%	2.50%	1.50%	2.40%
Asset Class Premia
Domestic Bonds	1.0%	1.0%	-3.0%	2.20%
Foreign Bonds	0.5%	2.0%	0.5%	3.65%
Domestic Property	3.0%	-10.0%	1.0%	-1.70%
Foreign Property	3.0%	-10.0%	-1.5%	-2.45%
Commodities	2.0%	-6.0%	3.0%	0.70%
Timber	2.0%	-8.0%	1.0%	-0.90%
Domestic Equity	3.5%	-12.0%	-5.0%	-4.40%
Foreign Equity	3.5%	-12.0%	-7.0%	-5.00%
Emerging Equity	4.5%	-15.0%	1.0%	-3.90%
Gold	-2.0%	2.0%	2.5%	3.75%
Volatility	-25.0%	50.0%	25.0%	29.90%

| Table: Market Implied Regime Expectations and Three Year Return Forecast | Uncorrelated Alpha Strategies Detail | Global Asset Class Returns | Table: One Year Asset Class Valuation Conclusions and Recent Momentum | Market Phase Change Risk Analysis | October 2009 Issue: Key Points | October 2009 Economic Update | Product and Strategy Notes: Challenges Facing Investors in Venture Capital Funds; Improving Warning of Future Financial Crises; A New View on the Fundamental Drivers of Equity Market Returns; and The Long-Term Impact of the 2007-2008 Crisis on Financial Advisers' Compensation | Feature Article: Equal Risk Weighted Portfolios in 2007 and 2008 | Global Asset Class Valuation Updates Detail | This Month's Letters to the Editor: Oil and Gas Partnerships - Do they fit in your portfolio?; What's the best Asset Allocation Today; Is it Possible to Over-diversify a Portfolio?; PIMCO Heavy Weighting for Emerging Markets, II's thoughts?; Timber Followup |